Matt Nolan

Multiple equilibrium and the drastic fall in oil prices

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The world price of oil has now declined to under $50US a barrel, a third of it’s peak value (live prices here).

This takes me back to a post we did at the end of May – when fuel costs were pushing up at a rate of knots. The topic was covered in the name: Collusion, multiple equilibrium, and petrol prices.

Now the fundamental argument was that, as petrol prices increase, net exporters face an increase in aggregate income and so want to save/invest more. Leaving oil in the ground is a form of investment. As a result, producing countries may reduce extraction in the face of higher prices (specifically if this has increase future expectations of prices). If all oil producers start doing this, then it pushes petrol prices up further and so on and so on. This implies two things:

  1. a small increase in demand may lead to a massive increase in prices,
  2. Even if demand is unchanged a small shock to prices may “push” us into a higher price “equilibrium”.

Now we also said that if this concept (which has been championed by Paul Krugman) had any power, a small decrease in international demand should lead to a collapse in prices and an INCREASE in fuel production (that cannot be explained by new oil fields coming online – also note that the increase is a sufficient condition, as long as production is higher than it would have been solely from a shift in the demand curve then this result would hold, and this could conceivably be at a lower level than prior to the shift in demand).

We’ve seen the price fall come to pass – but I have no data on the quantity yet. That will be very interesting to see.

3 replies
  2. Juan
    Juan says:

    Matt,

    Have you considered prices of crude oils may not be determined by supply and demand relations? Yes, I know such is hard to accept but does nevertheless rest in post-1986 changes in the oil price regime which was:
    1. The use of formula pricing as the multiple different grades of crudes came to be priced +/- in relation to a small number of benchmark grades such as WTI and Brent, while
    2. Price discovery of these benchmarks shifted into futures markets.

    OK, the above worked well enough so long as production and trade in the physical benchmark oils was sufficient to avoid thin market conditions and send an adequate signal — but by the late 1990s and owing to the decline in production, thin market conditions with assorted manipulations had developed sufficiently that, in 2000-01, Saudi Arabia, Kuwait, Iran, began pricing in reference to futures’ markets determined prices, i.e. in reference to the trade in paper barrels on the NYMEX and IPE.

    The price regime became financialized, less related to the real than the financial.

    Even this may not have been a problem were it not, from roughly 2002, financial players near simultaneous search for high returns from uncorrelated asset classes such as commodities, and the progressively larger flow of funds into these classes until a self-fulfilling price dynamic took over driving far beyond fundamentals. When the overpricing and its causes are recognized it’s hardly surprising that crisis driven asset liquifications have taken prices down dramatically.

    I attach the following less for content than internal links:
    Futures Prices Determine…

  3. Matt Nolan
    Matt Nolan says:

    “and the progressively larger flow of funds into these classes until a self-fulfilling price dynamic took over driving far beyond fundamentals”

    But this doesn’t explain what happened to the “inventories” of excess oil that would have developed if the price was above the level determined by supply and demand.

    We are in a market where supply and demand are both incredibly inelastic, and so the inventory accumulation would not be huge – however, inventories were consistently running BELOW forecasts over the past year.

    Without inventory accumulation I find the “bubble” story of oil prices hard to swallow.

    Of course the argument we have created in the post does allow for inventory accumulation – which is a function of price. In this case we only need slight changes in supply or demand conditions to cause a wild change in the equilibrium quantity and price of fuel. If anything this suggests to me that we may be in for a time of extreme volatility in prices – but not as a result of financial instruments.

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